The Most Important Question: 'What If My Investment Fails?'

After watching the Denver Broncos play the New England Patriots and lose 45-10, I caught a glimpse of Tim Tebow's post-game press conference. I remember one thing in particular that the Broncos quarterback said: "Obviously I wanted to win, but I can't be too upset because I gave my best effort and that's the best that anyone can do. I put it all out there on the field, and unfortunately, we came up short. And I'll still hold my head up high."

That comment impressed me for a number of reasons, but most of all, I appreciated Tebow's grace and class in the face of defeat. It takes a special strength of character and degree of security with oneself to hold one's head up high in the aftermath of failure. With this in mind, I think it can be quite worthwhile for investors to ask themselves the question, "What if one or more of my investments fail?" Based on how well I know myself, I'm not going to bet that every investment that I make over the next 30-40 years will work out well. Sure, I hope everything I own compounds at 11%-13% every year for decades on end (heck, why stop there, 20% annual compounding sounds nice in my imagination), but I doubt every investment I make will perform the way I envision it, and I want to get in the habit of preparing for realistic worst case scenarios.

I think that if you ask yourself the question, "What if my investments fail", you can most likely shed some light on two important components of your investing strategy: diversification and portfolio allocation rationale.

I know most people have their own formulas for trying to figure out the right approach to diversification, but I arrive at my answer for an appropriate level of diversification by considering what happens if my investments might turn out very poorly. By the time I reach the stage of my life where I hope to live off of the income generated by my stock holdings, I want to own about 40 companies. How did I arrive at this number? Well, first of all, I'm well aware that I'm not an infallible investor (in fact, I'm probably more fallible than most). If I had accumulated a 20 stock portfolio in 2008, I know that I would have owned General Electric (NYSE:GE), Wells Fargo (NYSE:WFC) and Wachovia. In the case of GE and Wells, I would have had to deal with significant income impairment for about 5 years or so, and in the case of Wachovia, I would have had to deal with about 5% of my wealth permanently destroyed for all intents and purposes (depending on the purchase price, the loss was in the vicinity of 90%).

The thought of having 5% of my portfolio wiped out through the failure of one company would bother me to the point that I wouldn't want a single stock holding to represent that much of my portfolio. However, if Wachovia were just one of 40 companies owned, I could deal with the 2.5% loss of my overall wealth as one of the costs of investing that stems from the recognition that I don't have perfect judgment. Now to be sure, this revelation about myself does come with some consequences. For instance, an extra percentage point or two over an investing lifetime can make a very substantial difference. $100,000 will grow to $1.2 million over 30 years at 8.5%. However, if you can get 10% annual returns for 30 years, that same $100,000 investment will turn into $2 million. Lynch was on to something when he introduced the term "diworsifcation" into the lexicon. Likewise, the more stocks I own, the more opportunities I have for failure. And if I own 40 companies, stocks like JP Morgan (NYSE:JPM) would make my list, and they too slashed their dividend heavily during the financial crisis, so there is not even a guarantee that my end result would be all that much better.

But still, I have to go with the allocation that I would be comfortable with. My natural aversion to avoid a 5% Wachovia-type wipeout is strong enough that I'd be willing to make the conscious decision to accept the hypothetically lower returns that comes with it. Aware of this, I will try to increase my savings rate throughout my lifetime to compensate for the potentially lower returns. And I should add this, what I mentioned about JP Morgan cuts both ways. For instance, J.M. Smucker Co. (NYSE:SJM) would make my top 40 list but not my top 20 list, so diversification would have opened me up to the possibility of experiencing Smucker's growth from $15 per share in 2000 to $81.04 today, plus a dividend that has grown from $0.63 per share in 2000 to $1.92 now. While I'm prepared to accept the potentially lower returns that might come my way by practicing a form of hyper-diversification, it may not necessarily have to play out that way: maybe "Stock #35" will give me returns well beyond my expectations to offset the sluggishness that we often associate with a large amount of different stock holdings.

And now for the second question that "what if my investments fail" can help to answer: portfolio allocation rationale. Thinking about investment failure adds a remarkable amount of clarity to my investment thesis for each company. For instance, I've expressed a lot of interest in my previous articles about hopefully building up sizable positions in the following five companies: Coca-Cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ), Colgate-Palmolive (NYSE:CL), Procter & Gamble (NYSE:PG) and PepsiCo (NYSE:PEP). To borrow from Rudyard Kipling's poem "If", I believe in my investment thesis for each of these companies strongly enough that if each of these companies failed spectacularly for me as investments, I could deal with losing and "never breathe a word about my loss." Why is that? Because the best thing I can do is act rationally and make decisions on the best information available to me at the time. Each of these companies sells products that people buy daily, they have exposure in almost every country, they have sizable moats and products with name brand recognition that grant them pricing power authority and healthy profit margins, and because of this, they all have very long track records of earnings growth and dividend growth that have spanned for decades. I doubt you could sit on one of those benches by the Wal-Mart (NYSE:WMT) bathrooms for more than an hour on a given afternoon without seeing someone buy a product owned by one of these five firms. If I can get a good price entry point for each of these companies, then I don't know what more I can ask for out of an an investment thesis. If I fail, I can deal with that because I'm making the best decision I can with the information I've got.

One of my friends owns a huge block of Exact Sciences (NASDAQ:EXAS) stock that he purchased at $5 and now trades at $9.07. He's read a couple of my articles, and doesn't forget to remind me that he has made more in the past year than I will likely make in the next six or seven. But that does not bother me one bit, because if I failed with an investment in a speculative small-cap biotech firm, I wouldn't be able to deal with that very well. Violating my "investment conscience" and then reaping bad consequences is something I want to make a priority to avoid. These are the kinds of things I can find out about myself if I ask the question, "What if my investments fail?" Your answers will probably take you in a different direction. But still, I think that the consideration of failure can quickly cut to the core of how you feel about diversification, portfolio allocation, and individual stock selection.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.